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Operational Investment and Capital Structure Under Asset-Based Lending This article was downloaded by: [129.59.208.78] On: 09 August 2019, At: 08:15 Publisher: Institute for Operations Research and the Management Sciences (INFORMS) INFORMS is located in Maryland, USA Manufacturing & Service Operations Management Publication details, including instructions for authors and subscription information: http://pubsonline.informs.org Operational Investment and Capital Structure Under Asset-Based Lending Yasin Alan, Vishal Gaur To cite this article: Yasin Alan, Vishal Gaur (2018) Operational Investment and Capital Structure Under Asset-Based Lending. Manufacturing & Service Operations Management 20(4):637-654. https://doi.org/10.1287/msom.2017.0670 Full terms and conditions of use: https://pubsonline.informs.org/page/terms-and-conditions This article may be used only for the purposes of research, teaching, and/or private study. Commercial use or systematic downloading (by robots or other automatic processes) is prohibited without explicit Publisher approval, unless otherwise noted. For more information, contact [email protected]. The Publisher does not warrant or guarantee the article’s accuracy, completeness, merchantability, fitness for a particular purpose, or non-infringement. Descriptions of, or references to, products or publications, or inclusion of an advertisement in this article, neither constitutes nor implies a guarantee, endorsement, or support of claims made of that product, publication, or service. Copyright © 2018, INFORMS Please scroll down for article—it is on subsequent pages INFORMS is the largest professional society in the world for professionals in the fields of operations research, management science, and analytics. For more information on INFORMS, its publications, membership, or meetings visit http://www.informs.org MANUFACTURING & SERVICE OPERATIONS MANAGEMENT Vol. 20, No. 4, Fall 2018, pp. 637–654 http://pubsonline.informs.org/journal/msom/ ISSN 1523-4614 (print), ISSN 1526-5498 (online) Operational Investment and Capital Structure Under Asset-Based Lending Yasin Alan,a Vishal Gaurb a Owen Graduate School of Management, Vanderbilt University, Nashville, Tennessee 37203; b Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853 Contact: [email protected], http://orcid.org/0000-0002-5220-7578 (YA); [email protected] (VG) Received: March 7, 2017 Abstract. Problem definition: Banks commonly use asset-based lending (ABL) to provide Revised: June 13, 2017 loans collateralized by a borrower firm’s inventory. We study the implications of ABL Accepted: August 11, 2017 by examining how banks should determine asset-based loan terms based on firms’ oper- Published Online in Articles in Advance: ational characteristics (e.g., inventory salvage value and demand uncertainty) and how May 24, 2018 firms should make inventory stocking and capital structure decisions under asset-based https://doi.org/10.1287/msom.2017.0670 borrowing constraints. Academic/practical relevance: Despite its widespread use for lending to small firms and those with large inventory investments, such as retailers, ABL has not Copyright: © 2018 INFORMS been well studied in the literature. Methodology: We analyze ABL using a stylized single- period screening game of incomplete information between a business owner and a bank. The bank offers a menu of loans, where each loan offer is characterized by an interest rate and inventory advance rate. The owner then decides the inventory level and the mix of debt and equity with which to finance the firm’s operations. Our model captures the prac- tical features of ABL, for example, the bank does not have the full knowledge of the firm’s demand prospects, and the inventory advance rate leads to a credit limit that increases in the firm’s inventory investment. Results: We show that ABL enables the bank to miti- gate information asymmetry by screening firms and thereby controlling each firm type’s order quantity and leverage. We also obtain hypotheses describing the equilibrium loan contracts, capital structure, inventory investment, and bankruptcy outcomes. For instance, leverage leads to overinvestment resulting from the equity decision being endogenous to the model. Moreover, inventory advance rates are more sensitive to firms’ operational characteristics than interest rates. Managerial implications: Our study sheds light on the operational and financial implications of ABL by demonstrating how managers should make inventory and capital structure decisions while interacting with asset-based lenders. Supplemental Material: The online appendix is available at https://doi.org/10.1287/msom.2017.0670. Keywords: operations–finance interface • inventory management • capital structure • bankruptcy risk • capital market frictions 1. Introduction of capital structure in corporate finance typically do not We study the problem of a bank providing an asset- include the details of operational decisions whereas based loan to a firm that faces the newsvendor prob- the operations–finance interface models in operations lem. The firm makes an operational investment deci- management typically do not include the interaction of sion, that is, the amount of inventory to buy to meet a firm with a lender under asymmetric information or random demand, and a capital structure decision, that endogenous equity decisions. We address these ques- is, the mix of debt and equity with which to finance tions in this paper in the context of asset-based lending its operations. The bank sets the terms of the loan (ABL), which is a method commonly used by banks to offer under asymmetric information about the demand lend money to businesses. faced by the firm. This relationship necessitates a num- In ABL, a borrower firm offers its current assets, ber of questions: How does the operational investment which include its inventory, cash, and account receiv- of the firm vary with its capital structure? What loan ables, as collateral for a secured loan. The bank values terms should the bank offer to the firm? How is the the current assets and thereby sets loan terms for the equilibrium outcome affected by information asymme- firm, which consist of an interest rate and an advance try and the operational parameters of the firm, such rate for each type of current asset. The advance rate as its demand uncertainty and price–cost economics? specifies the bank’s valuation of the asset as a per- The importance of these questions is well recognized in centage of its balance sheet value. For instance, a 60% the literature, but solutions are not readily available in advance rate on inventory means that the bank is will- part because this problem falls at the interface of oper- ing to lend the firm an amount up to 60% of the pro- ations management and corporate finance. The models curement cost of its inventory. ABL is useful to banks 637 Alan and Gaur: Operational Investment and Capital Structure Under Asset-Based Lending 638 Manufacturing & Service Operations Management, 2018, vol. 20, no. 4, pp. 637–654, © 2018 INFORMS and borrowers alike. For the bank, it mitigates the and manages its operations. The business can be of two cost of information asymmetry by imposing a credit types that differ in the distribution of demand and are limit and alleviates a problem of incomplete contract- identical in all other respects. The type of the firm is ing by giving the bank a senior right to foreclose on the known to the owner but not to the bank. firm’s assets and liquidate them in a default state (Hart Our main results are as follows. First, we find that and Moore 1998). Consequently, asset-based loans typ- the two components of the loan terms, interest rate ically require less monitoring and simpler financial and advance rate, play different roles. Interest rates pri- covenants (OCC 2014) and may carry lower interest marily respond to changes in the owner’s opportunity rates than unsecured loans (Caouette et al. 2011). These cost of equity and are relatively insensitive to newsven- features are useful to companies with large current dor model parameters, that is, demand uncertainty assets, such as retailers. They also make ABL accessi- and inventory salvage value. In contrast, advance rates ble to small businesses, which typically do not have are highly sensitive to a firm’s operational character- access to cash flow financing availed by large compa- istics. For example, with respect to the salvage value, nies with revenues in excess of $25 million and stable the average interest rate varies in the range of 10% profits (Burroughs 2008). to 11.2% whereas the average advance rate varies in ABL is a large industry. The total amount of out- the range of 45% to 95% in an extensive numerical standing asset-based loans in the United States ranged study. Thus, ABL enables the bank to screen firms and from $314 to $590 billion during 2000 to 2009 (CFA thereby control each firm type’s order quantity and 2009), which constituted about 25% of the total amount leverage. Compared with an alternative lending model of loans and short-term papers issued to nonfinan- in which the bank optimizes the interest rate with- cial corporations.1 Asset-based loans secured solely by out imposing an asset-based credit limit, we find that inventory are common in practice, especially in the ABL is most beneficial to the bank under more adverse retailing industry (Foley et al. 2012; GE Capital 1999, lending conditions, such as a low salvage value or a p. 14), which is one of the top three asset-based bor- high demand uncertainty and that ABL leads to a 23% rowers (CFA 2009). We provide specific loan examples higher expected profit for the bank, greater availability in Section3. of lending, lower interest rates, and lower bankruptcy Despite its practical usage and dependence on inven- probabilities. tory stocking decisions, ABL has not been well stud- Second, the equilibrium order quantity under lever- ied in the operations literature. A lone exception is age is always greater than or equal to that under the Buzacott and Zhang (2004), who introduce ABL to the pure equity solution.
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